Such sanctions could involve suspending EU funds for Croatia's border controls. They would be an embarrassment for the Balkan country just two months after it joined the bloc.
The law was adopted just a day before Croatia formally became an EU member on July 1. It prohibits Croatian citizens from being extradited to foreign countries, which goes against EU practice.
Mina Andreeva, a spokeswoman for the EU justice commissioner, said Monday that the European Commission is preparing the sanctions this week.
Andreeva said that despite sustained pressure on Croatia since it joined, "we have not seen a response" that satisfies EU demands for an "unconditional change" of the law.
However, Croatia's parliament speaker, Josip Leko, said he does not expect any "material" consequences from the sanctions, adding he is "confident the government will know how to react and protect Croatia's interests."
Nevertheless, the nationalist opposition urged the government to urgently amend the law, and Croatia has said it will move to change the legislation, which was officially intended to protect veterans of its 1991-95 war for independence from prosecution abroad.
The opposition says the law is, in fact, intended to protect former Croatian intelligence chief Josip Perkovic—who is sought by Germany in the murder of a Croatian dissident allegedly assassinated by the former Yugoslav secret service in Germany in the 1983. Perkovic, who created Croatia's secret service once Croatia split from the former Yugoslavia in the 1990s, worked for the Communist Yugoslavia's secret service in the 1980s.
AP writer Dusan Stojanovic contributed to this report